It is hardly news that ESG investing is a significant aspect of the asset management industry. According to Barron’s, $400 billion was invested in U.S. mutual funds and assets that have an ESG orientation in 2021. However, it remains a challenge for issuers, asset managers, regulators and other industry participants to determine whether a particular business, industry, or product promotes or is harmful to ESG considerations. The Russian invasion of Ukraine shines a spotlight on this larger issue due to shifting attitudes about “defense stocks”—e.g., stock in weapons and ammunition manufacturers and other companies in the defense industry. The defense industry does not immediately come to mind when thinking about ESG issues. From an environmental perspective, weapons production has a high carbon footprint. Conservative estimates place national defense at more than 50 percent of governments’ carbon emissions. From a social perspective, defense spending has historically been viewed as contrary to social good and welfare. But in light of recent events, public opinion, even viewed through the ESG lens, has seemed to shift away from the potentially harmful environmental impact of the industry towards the potentially positive social impact it may have in the defense against a harmful geopolitical actor. Analysts suggest that “defense is likely to be increasingly seen as a necessity that facilitates [ESG] as an enterprise, as well as maintaining peace, stability and other social goods.”
The notion that a particular business or product can give rise to tension between the environmental and social aspects of ESG, or raise disputes about whether it is sustainable or socially beneficial at all, is not limited to the defense industry. For instance, in the United States, there have been significant investor complaints and confusion, as well as regulatory scrutiny surrounding the question of what constitutes a “sustainable” company. Just ask Oatly, a Swedish oat milk producer and self-described sustainable company that faced significant backlash and was “cancelled” on social media after it sold a significant equity interest to a high-profile group of investors led by a private equity firm whose portfolio also includes investments in corporations accused of contributing to climate change and other unsustainable practices. Though Oatly applies sustainable practices in its production process, environmental activists, including some shareholders, argued that Oatly was doing more harm than good to overall sustainability by accepting these investments. However, as discussed below, this type of black and white approach does little to help assess whether a particular investment is consistent with ESG principles. Rather, ESG investing requires far more nuanced assessments that take into account, among other things, the managers’ historical statements about its ESG investing approach, the investors’ particular ESG appetite, and taxonomic classifications of the product or business. From the perspective of the private equity firm that invested in Oatly, investment in a sustainable brand could signal that sustainability can be profitable. Likewise, the defense industry illustrates the difficulties in taking a “one-size-fits-all” approach to classifying companies or products as “ESG-compliant” or not. Another example is natural gas, which, under certain circumstances, was classified as green in the EU Taxonomy Regulation (the “EU Green Taxonomy”), raising protests from various quarters about this classification. But in justifying its decision, the European Commission pointed out that “there is a role for natural gas and nuclear as a means to facilitate the transition towards a predominantly renewable-based future.” Thus, while there are any number of examples, the defense industry provides a useful lens through which to examine the challenges for the asset management industry in classifying investments as sustainable or not.
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